Redemption possible if Merkel bends

So far during the pullback in global equity markets, I’ve remained cautiously optimistic that what we’re seeing is merely yet another correction in a larger uptrend from the market bottom in early 2009. And events over the past week have given me a little more confidence that this optimism remains well founded.

Of course, Europe is central to all current global equity market concerns. Fears of a messy Greek exit from the euro zone, with inevitable contagion effects in Italy and Spain, have left investors extremely nervous.

But perhaps there’s light at the end of Europe’s long and dark tunnel.

Indeed, there’s growing talk of a European “debt redemption fund", which seems a plausible way for the troubled region to at least kick its can of problems a lot further down the road.

The beauty of this fund is it may at least quarantine Italy and Spain from contagion effects should Greece fail to keep itself in the euro zone.

If so, it would be great news for Australia’s battered equity market, though it would also likely mean the Reserve Bank won’t slash interest rates over the coming year as aggressively as the market currently thinks.

A European reprieve, and even a mooted new Chinese infrastructure stimulus package, could also provide at least a temporary bounce to the Australia dollar, pushing it back above parity with the greenback.

While the proposed debt redemption fund still has its challenges, it’s shaping up as one of the least-bad solutions to Europe’s current woes. In effect, such a fund would issue bonds that attracted a euro-zone-wide repayment guarantee and the proceeds from their sale would be used to pay down maturing sovereign debt in each euro zone country, until each country’s sovereign debt exposure outside of the fund was reduced to 60 per cent of national output.

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While each country that used the fund would still need to pay its share of the redemption fund’s interest costs, the collective guarantee would probably mean refinancing costs would be lower for troubled countries such as Italy and Spain, making their budget challenges less onerous.

Of course, for Germany funding costs would end up being a little higher, but perhaps less costly for taxpayers than allowing the euro zone to fall apart.

Strict conditions would be attached to using the fund. These include no increase in debt levels outside of the fund, and adherence to a timetable to pay down debt accumulated in the redemption fund over 25 years.

Even budget revenues in each member state would be earmarked to make interest payments to the fund.

Compared with the more basic “euro bond" idea, this redemption fund still imposes conditionality on countries to reduce their debt exposures over time, albeit in a more manageable way than currently available.

But perhaps the strongest argument in favour of a redemption fund is that the obstinate Germans might accept it. After all, it’s a German idea. It was first proposed late last year by Germany’s own Council of Economic Experts, a group of eminent economists set up to advise the government on economic issues.

And given Germany has a public debt to GDP ratio above 60 per cent of national output, it would itself be one on the fund’s biggest users, thereby reducing the stigma on other countries using it. Indeed, German debt would make up around one quarter of the fund and Italian debt 40 per cent.

After blocking attempts by other European countries to introduce euro bonds last week, and pouring cold water on the redemption fund idea last year, new reports suggest German Chancellor
Angela Merkel
could be warming to the latter, least-bad, idea.

Indeed, with German opposition parties urging Merkel to reconsider the redemption fund, she seems to have unusually good political cover to embrace it.

The next steps in Europe remain unclear, but it would not surprise to see confidence in global markets return with the warming prospects of an eventual European redemption fund.

Meanwhile, further good news could soon come from China, with reports suggesting a new infrastructure-based stimulus package could be on the way. China has recently acknowledged a deepening economic slowdown, and Premier
Wen Jiabao
signalled he would give more priority to fostering growth.

So far at least, China has yet to unveil a “big bang" stimulus package of the type last seen in late 2008, but it certainly has the mean to provide a targeted boost to ailing sectors of the economy should it see fit.

All that said, based on domestic considerations alone, to my mind the Reserve Bank of Australia still probably has at least one or two quarter of a percentage point rate cuts in mind before year-end.

Indeed, economic reports due this week are likely to provide further evidence of Australia’s two-speed economy in the form of modest retail sales growth, flat home building approvals, yet booming mining business investment.